High Performance Graham Stocks
Over the past four years I've used Benjamin Graham's time-tested strategy for defensive investors to uncover undervalued U.S. stocks. In many ways my series on Graham stocks was well timed because, after years of underperformance in the late 1990s, value stocks staged a strong comeback in the early 2000s. Graham's approach has certainly benefited from changed market sentiment and I'm happy to report another year of stellar returns.
Benjamin Graham first outlined his rules for defensive investors in The Intelligent Investor which has been in bookstores for more than fifty years. An updated edition of The Intelligent Investor (ISBN 0060555661) was released last year with new commentary from veteran Money Magazine columnist Jason Zweig. I had the pleasure of reading the new edition this summer and my initial fear that Graham's original text would be corrupted by Zweig's commentary was unfounded. The original text is presented in its entirety with Zweig's commentary provided in footnotes and at the end of each chapter. Overall, the new commentary is properly placed and provides interesting modern examples based largely on Graham's principles. All told, I was pleased with my purchase of the newest version of The Intelligent Investor.
I've summarized Graham's rules for defensive investors in Figure 1 with one omission. When testing for financial stability, Graham imposed a current ratio requirement and he also wanted stocks with long-term debt less than net current assets (current assets less current liabilities). He modified this rule for utilities where he wanted debt to be less than double shareholder's equity. In the past I've neglected to include this criteria but I hope that you'll forgive my oversight. Keep in mind that searching for stocks using Graham's original criteria is often fruitless because his criteria are very strict.
To implement my less-stringent version of Graham's rules I continue to use the MSN.com stock screener. The MSN.com screener doesn't have the wealth of historical data needed to fully implement Graham's rules and, as a result, I trimmed down Graham's rules to those shown in Figure 2. Even with these relaxed rules, only nine stocks met my criteria in 2000, five in 2001, ten in 2002, and two in 2003. This year the selection is a bit better with five stocks passing the test. Keep in mind that there are over 6,750 stocks in the MSN.com database which makes the five Graham stocks quite unusual.
The nine picks of 2000 continue to do quite well with all nine showing profits. A stock by stock breakdown is shown in Table 1 and the average gain is very healthy at 123.0%. Given that the S&P500 fell by 14.8% over the same period, the Graham stocks managed a remarkable outperformance of 137.8 percentage points over four years.
The five picks of 2001 can boast even better performance with an average gain of 157.5%. Table 1 shows that the worst individual performer from 2001 gained over 36% and the best performer gained 261.7%. Again the index fell behind with the S&P500 climbing only 8.1% over the same period which translates into a superior outperformance of 149.4 percentage points for the 2001 Graham stocks.
2002's picks were also strong with an average gain of 121.2% and individual stocks gaining between 47.6% and 178.3%. Since 2002 the S&P500 trailed the Graham stocks by 93.8 percentage points but managed reasonable gains of 27.4% over the same period.
Last year only two stocks passed Graham's tests but they managed an average gain of 32.2% which is 22.8 percentage points more than the S&P500 which gained 9.4% over the same period.
Clearly Graham's defensive approach has done more than well but such extraordinary results are unlikely to continue. It has been my experience that periods of significant outperformance are usually followed by periods of severe underperformance. Be warned that buying into a style that has recently done well is no guarantee that it will continue to do well. Mind you, I've also been making this warning for years and it has yet to come true. However, it is important to err on the side of prudence and not to become overly enchanted by outsized gains.
This year's crop of Graham stocks is shown in Table 2. Since stocks can move rapidly, I suggest checking the MSN.com screener to be sure that the stocks in Table 2 continue to fit Graham's criteria.
Also be aware that stock screeners can be deceptive at times because they aren't always up to date. For example, if a company runs into trouble then its stock may continue to be highlighted by the screener as good pick based on old data. I often find stocks that look good to a stock screener but aren't good for a portfolio. It is also a good idea to look for some indication that a company's situation has remained largely unchanged before buying. For instance, looking at recent news stories on the company often helps to separate the wheat from the chaff.
Naturally, you should examine any stock in detail before investing and holding only five stocks is not recommended. Be cautious before jumping into any investment and talk over potential purchases with your investment advisor. Furthermore, deep value picks can be psychologically difficult for many investors and a few beaten-up stocks inevitably fail. Thus far, Graham's method has avoided running into a land mine but it is only a matter of time. I'm particularly concerned that some people might be inclined to chase after performance and won't fully realize what they are getting into. Be sure to know what you're investing in and proceed with caution.
First published in the November 2004 edition of the Canadian MoneySaver magazine.
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